1. © 2002 South-Western Publishing 1 Chapter 13 Swaps and Interest Rate Options

2. 2 Outline Interest rate swaps Foreign currency swaps Circus swap Interest rate options

3. 3 Introduction Both swaps and interest rate options are relatively new, but extensively used – In mid-2000, there was over $60 trillion outstanding in interest rate swaps, foreign currency swaps, and other interest rate options

4. 4 Interest Rate Swaps Hedging with interest rate swaps Immunizing with interest rate swaps Exploiting comparative advantage in the credit market

5. 5 Interest Rate Swaps Popular with bankers, corporate treasurers, and portfolio managers who need to manage interest rate risk A swap enables you to alter the level of risk without disrupting the underlying portfolio: asset liability

6. 6 Interest Rate Swaps The most common type of interest rate swap is the fixed for floating rate swap – One party makes a fixed interest rate payment to another party making a floating interest rate payment – Only the net payment is made (difference check) – The firm paying the floating rate is the swap seller – The firm paying the fixed rate is the swap buyer

7. 7 Interest Rate Swaps Typically, the floating interest rate is linked to a market rate such as – LIBOR or – T-bill rates – BA’s in Canada The swap market is standardized partly by the International Swaps and Derivatives Association (ISDA) – ISDA provisions are master agreements

8. 8 ‘Plain Vanilla’ Swap – Hedging Interest Rate Risk A plain vanilla swap refers to a standard contract with no unusual features or bells and whistles The swap facilitator will find a counterparty to a desired swap for a fee or take the other side – A facilitator acting as an agent is a swap broker – A swap facilitator taking the other side is a swap dealer (swap bank)

9. 9 Plain Vanilla Swap Plain Vanilla Swap Example A large firm pays a fixed interest rate to its bondholders, while a smaller firm pays a floating interest rate to its bankers The two firms could engage in a swap transaction which results in the larger firm paying floating interest rates to the smaller firm, and the smaller firm paying fixed interest rates to the larger firm

10. 10 Plain Vanilla Swap - Motivations Large firm with a strong credit rating takes advantage of it s borrowing capacity and borrows fixed term in the bond market interest rate outlook - declining rates enters into a swap agreement to move to floating rate debt but still leveraging its strong credit rating and borrowing capacity

11. 11 Plain Vanilla Swap - Motivations Smaller firm with weaker credit rating no/minimal access to long term bond market due to its relatively weak credit rating typically borrows floating rate from its bank(s) would like to fix its borrowing rate as part of its risk management program can achieve its fixed rate objectives by entering into a swap agreement

12. 12 Plain Vanilla Swap Plain Vanilla Swap Example (cont’d) Big FirmSmaller Firm BondholdersBankers LIBOR – 50 bp 8.05% LIBOR +100 bp

13. 13 Plain Vanilla Swap Plain Vanilla Swap Example A facilitator might act as an agent in the transaction and charge a 15 bp fee for the service.

14. 14 Plain Vanilla Swap Plain Vanilla Swap Example Big FirmSmaller Firm Bondholders Bankers 8.05%LIBOR +100 bp Facilitator LIBOR -50 bp 8.05%8.20% LIBOR -50 bp

15. 15 Plain Vanilla Swaps - Timing Swaps can be entered into at same time the firm accesses the bond market - e.g. 5 year fixed rate bond issue immediately swapped into floating rate via a swap agreement or A swap can be negotiated at any time over the life of an existing borrowing e.g. 7 year bond issue two years prior - firm now expects interest rates to decline - 5 years remaining on the bond issue - firm enters into a 5 year fixed to floating rate swap

16. 16 Plain Vanilla Swap The swap price is the fixed rate that the two parties agree upon The tenor is the term of the swap The notional value determines the size of the interest rate payments Counterparty risk refers to the risk that one party to the swap will not honor its part of the agreement

17. 17 Interest Rate Risk Management - Considerations Interest rate outlook over expected borrowing horizon – Use swaps where the borrowing horizon is longer term – use futures where the interest rate risk is short term absolute interest rate levels and or yield curve shape credit or ‘swap’ spreads

18. 18 Immunizing With Interest Rate Swaps Interest rate swaps can be used by corporate treasurers to adjust their exposure to interest rate risk The duration gap is:

19. 19 Immunizing With Interest Rate Swaps (cont’d) A positive duration gap means a bank’s net worth will suffer if interest rates rise – The treasurer may choose to move the duration gap to zero This could be accomplished by selling some of the bank’s loans and holding cash equivalent securities instead or using interest rate swaps to close the duration gap

20. 20 Exploiting Comparative Advantage in the Credit Market Interest rate swaps can be used to exploit differentials in the credit market

21. 21 Exploiting Comparative Advantage in the Credit Market Credit Market Example AAA Bank and BBB Bank currently face the following borrowing possibilities: FirmFixed RateFloating Rate AAACurrent 5-yr T-bond + 25 bp LIBOR BBBCurrent 5-yr T-bond + 85 bp LIBOR + 30 bp Quality Spread60 bp30 bp

22. 22 Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d) AAA Bank has an absolute advantage over BBB in both the fixed and the floating rate markets. AAA has a comparative advantage in the fixed rate market. The total gain available to be shared among the swap participants is the differential in the fixed rate market minus the differential in the variable rate market, or 30 bps.

23. 23 Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d) AAA Bank wants to issue a floating rate bond, while BBB wants to borrow at a fixed rate. Both banks will borrow at a lower cost if they agree to an interest rate swap. AAA Bank should issue a fixed rate bond because it has a comparative advantage in this market. BBB should borrow at a floating rate. The swap terms split the rate savings 50-50. The current 5-yr T-bond rate is 4.50%.

24. 24 Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d) AAABBB Bondholders Treasury + 40 bp LIBOR Treasury + 25 bpLIBOR +30 bp

25. 25 Exploiting Comparative Advantage in the Credit Market Credit Market Example (cont’d)  The net borrowing rate for AAA is LIBOR – 15 bps  The net borrowing rate for BBB is Treasury + 70 bps  The net rate for both parties is 15 bps less than without the swap.

26. 26 Foreign Currency Risk 1971 – the Breton Woods Agreement was suspended by global monetary leaders Currencies previously tied to the price of gold and to the $US now floated freely The result- currency volatility and currency risk 1972 – CME began trading currency futures 1981 – Salomon Bros brokered the first currency swap between the World Bank and IBM (German marks Swiss francs)

27. 27 Foreign Currency Risk Today ‘Euro’ volatility Weakening US dollar Strengthening Canadian dollar (other ‘resource currencies) – Impacted Canadian firms and individual investors – E.g. oil & gas producers selling commodities denominated in $US and Canadian investors investing in US securities

28. 28 Foreign Currency Swaps In a currency swap, two parties – Exchange currencies at the prevailing exchange rate – Then make periodic interest payments to each other based on a predetermined pair of interest rates, and – Re-exchange the original currencies at the conclusion of the swap

29. 29 Foreign Currency Swaps (cont’d) Cash flows at origination: Euro Principal C$ Principal Cdn. Co.Swap Dealer Bondholders C$ Fixed Rate Interest

30. 30 Foreign Currency Swaps (cont’d) Cash flows at each settlement: Euro Fixed Rate C$ - Fixed Rate Cdn. Co.Swap Dealer C$ Fixed Rate Interest

31. 31 Foreign Currency Swaps (cont’d) Cash flows at maturity: Euro Principal C $ Principal Cdn. Co.Swap Dealer Retire C$ Issue

32. 32 Circus Swap Combining both interest rate and currency swaps

33. 33 Circus Swap A circus swap combines an interest rate and a currency swap – Involves a plain vanilla interest rate swap and an ordinary currency swap – Both swaps might be with the same counterparty or with different counterparties

34. 34 Circus Swap Interest associated with original currency swap Euro - Fixed C$ - Fixed Cdn. Co.Swap Dealer Bondholders Fixed C$ Interest

35. 35 Circus Swap Interest rate swap to move from fixed euros to floating rate euros Euro Fixed Euro Floating Cdn. Co.Swap Dealer

36. 36 Circus Swap Circus swap with two counterparties = net position of: Floating Rate Euros Fixed Rate C$ Cdn. Co.Swap Dealer Fixed C$ Interest

37. 37 Swap Variations Deferred swap Floating for floating swap Amortizing swap Accreting swap

38. 38 Deferred Swap In a deferred swap (forward start swap), the cash flows do not begin until sometime after the initiation of the swap agreement Motivation - desire to manage future interest rate risk but reflecting today’s interest rate conditions

39. 39 Deferred Swap - Example ABC corporation has a required borrowing 2 years from now interest rate outlook is for rates trending upward deferred swap could lock in today’s fixed rates for a premium a deferred or forward swap is in effect 2 swaps

40. 40 Deferred Swap - Example ABC Co. Swap Dealer Swap Dealer Pay 7 year Fixed Receive BA’s Pay BA’s Pay 2 year Fixed

41. 41 Deferred Swap - Example ABC Co.Swap Dealer Pay 7 year (5 years remaining) Fixed Receive BA’s...in two years time Bankers Borrow Floating Rate BA’s

42. 42 Deferred Swap - Dealer factors in the ‘cost of carry’ in offering the deferred 5 year rate (one swap) Considerations – interest rate outlook – time frame – cost of carry - the cost of the ‘hedge’ steep yield curve - higher cost of carry flat yield curve - minimal cost of carry

43. 43 Floating for Floating Swap In a floating for floating swap, both parties pay a floating rate, but with difference benchmark indices

44. 44 Amortizing Swap In an amortizing swap, the notional value declines over time according to some schedule

45. 45 Accreting Swap In an accreting swap, the notional value increases through time according to some schedule

46. 46 Interest Rate Options Interest rate cap Interest rate floor Calculating cap and floor payoffs Interest rate collar Swaption

47. 47 Interest Rate Options Most of the trading done off the exchange floors The interest rate options market is – Very large – Highly efficient – Highly liquid – Easy to use

48. 48 Interest Rate Options

49. 49 Interest Rate Cap An interest rate cap – Is like a portfolio of European call options (caplets) on an interest rate On each interest payment date over the life of the cap, one option in the portfolio expires – Is useful to firms with floating rate liabilities – Caps the periodic interest payments at the caplet’s exercise price

50. 50 Interest Rate Cap (cont’d) Long interest rate cap (exercise price 7%) $ Payoff Option expires worthless 7% Floating Rate Payoff

51. 51 Interest Rate Cap (cont’d) Short interest rate cap (exercise price 7%) $ Payoff Option expires worthless 7% Floating Rate Payout

52. 52 Interest Rate Floor An interest rate floor – Is related to a cap in the same way that a put is related to a call – like a portfolio of European put options (floorlets) on an interest rate On each interest payment date over the life of the cap, one option in the portfolio expires – Is useful to firms with floating rate assets – Puts a lower limit on the periodic interest payments at the floorlet’s exercise price

53. 53 Interest Rate Floor (cont’d) Long interest rate floor (exercise price 6.5%) $ Payoff Option expires worthless 6.5% Floating Rate Payoff

54. 54 Interest Rate Floor (cont’d) Short interest rate floor (exercise price 6.5%) $ Payoff Option expires worthless 6.5% Floating Rate Payout

55. 55 Calculating Cap and Floor Payoffs There are no universally acceptable terms to caps and floors – OTC instruments customized to meet needs of both parties However, frequently the terms provide for the cash payment on an in-the-money caplet or floorlet to be based on a 360-day year

56. 56 Calculating Cap and Floor Payoffs (cont’d) Cap payout formula: If the benchmark rate is less than the exercise price, the payout is zero …..all in borrowing cost will be hedged at the strike price plus the option premium

57. 57 Calculating Cap and Floor Payoffs (cont’d) Floor payout formula:

58. 58 Interest Rate Collar An interest rate collar is simultaneously long an interest rate cap and short an interest rate floor Sacrifices some upside potential in exchange for a lower position cost – Premium from writing the floorlets reduces position costs

59. 59 Interest Rate Collar (cont’d) $ Payoff k2k2 Floating Rate Inflow Outflowk1k1 No payout Long cap Short floor

60. 60 Swaption A swaption is an option on a swap Can be either American or European style A payer swaption (put swaption) gives its owner the right to pay the fixed interest rate on a swap A receiver swaption (call swaption) gives its owner the right to receive the fixed rate and pay the floating rate